Digital Policy #3: Startup Investment and Taxes

During the current credit crunch, you can imagine that getting startups financed is a big challenge. And, you’d be totally right. In Canada, with our rapidly diminishing venture capital system, startup financing was tough long before the current financial situation.

Yet, for our economy the healthy generation and regeneration of young companies is a motor that drives our future economic well being – or doesn’t. The startup economy represents the most likely path to diversify beyond such industries as automotive manufacturing (a just over 100 year old industry), not to mention to find the next Research in Motion’s.

Hot sectors like web, mobile, green technology and life sciences, transform knowledge and research into valuable commercial businesses via a healthy appetite for capital. In another post, we’ll examine why, particularly in Canada, there is less insitutional capital, such as venture capital, available to these startups. We’ll also examine issues like international visibility of Canadian technology, LSIFs, historical returns and the like.

With institutional capital frozen like never before, we are reliant upon angels, high net worth individuals, strategic investors and friends and family like never before to build our startup future. As a result, I’d like to focus on measures that our federal and provincial governments can take to increase capital investment flowing to startups.

Here, in no particular order, are a few sample issues with our tax system and recommended approaches to removing such barriers investment:

Simplify those parts of our tax system, such as the necessity to have complex and expensive Exchangeable Sharesto implement many cross border structures and M&A transactions. In particular, many startups build Canadian-based global business and, as such, need to have global (often US) structures around Canadian-centred operations. Right now, the strctures necessary to achieve global value, are unreasonably expensive.

Likewise, the key Scientific Research and Experimental Development (SR&ED) refundable tax credit is critical for many early stage companies. The costly structural intricacies of keeping Canadian Controlled Private Corporation (CCPC) status through many cross-border and financing transactions needs to be simplied. Almost every company I’ve worked with or invested in has spent tens (if not hundreds) of thousands of dollars in CCPC workarounds.

Many common early stage investment approaches, such as convertible debentures, can be a challenge for angel investors. These typically pay a “coupon rate” of interest which is almost never actually paid out, but instead converted into additional equity in the early stage business. Although received in equity rather than cash, CRA treats this “accrued interest” as income. While many individuals and big institutional investors with their Limited Partnership structures generally get tax deferral on this accrued interest, simpler corporate and holding company structures don’t. The increased legal and accounting complexity to work around this often acts as another barrier to early stage investment.

Many of the issues that affect employees and management of startups that we discussed in Digital Policy #2: Taxing Talent Down the (Brain) Drain also intersect with the angel investment community. For example, many serial entrepreneurs adopt a “hands-on” investment model in which they invest both talents and returns garnered from previous successes.

Ideally, without the government getting into the problematic business of “picking winners”, taxes could really jump start investment. For example, a tax strategy to allow tax free “roll overs” on gains from one investment to be injected into another business without triggering the gain, could be extremely effective. In this model, the tax would be payable only when the money was taken out of active investment.

Going even further, instead of LSIFs, tax policy could be designed to top up certain qualifying angel rounds. Clearly good design would be essential, but the main strategy would be to piggy back on investment decisions and risks being taken by investors. This could be implemented either as a tax credit (as with LSIFs) or potentially through a separate matching investment body which would back existing deals.

A direct outcome of undue tax system complexity, is that it acts as a brake on investment. As a country our future depends on healthy investment in the businesses that will build future prosperity. We are a nation of talented, global thinkers. But, without the capital to harness that passion and energy, we risk losing the economic strength we all have come to take for granted.

While it may not be the sexiest topic during our current campaign, this area may well be one of the most important.